Don't Get Burned by the New Tech Bubble

Is there still any doubt about whether or not we're seeing a new tech bubble?

LinkedIn Corp. (NYSE: LNKD) is down some more than 30% from since its initial public offering (IPO) and Pandora Media Inc. (NYSE: P), which had a strong debut just last week, has dropped 35%.

Indeed, billion-dollar valuations for companies like Pandora and online coupon site Groupon Inc. have lured tech-hungry investors into buying what they think is the next big Internet stock. But the reality is that these companies are driving demand through low-float IPOs and undeliverable growth promises.

Investors need to understand that despite the excitement surrounding Internet and social media companies, the chance that these businesses will deliver on profitability promises is slim to none.

The fact that these companies were able to garner as much investor interest as they did raises a red flag that suggests a new tech bubble has formed - and is ready to burst.

"It's 1999; I wouldn't touch any of them," said Money Morning Contributing Editor Martin Hutchinson. "Every possible warning bell is telling me this is a bubble and we're close to its maximum inflation."

Beware the Low-Float IPO

Pandora's IPO was initially expected to go for $7 to $9, but doubled to a $16 per share offer price. When trading started Wednesday, its shares soared more than 40% in the first hour, but closed only 8.9% higher. Then they promptly fell about 23% on day two.

Now shares are down about 35% from the IPO price - and many investors wonder why they were so quick to buy in.

Analysts partly blame Pandora's low-float IPO strategy. A low-float IPO drives demand because investors think they will be shut out of a chance to get the stock at a good price and they act more impulsively, ignoring fundamentals. The strategy has been especially effective this year, as buzz around tech stocks has stoked pent-up investor demand.

"If you're dying of thirst, you'll accept iced tea even if you really want lemonade," Max Wolff, senior analyst at GreenCrest Capital, told CNNMoney. "It's a perfect storm of fury, frustration, excitement and delay."

Pandora floated only 9.2% of shares, far below the 24% average float for U.S. tech IPOs in the past year.

Caught up in the thrill of the chase - lots of investment dollars are chasing a small amount of available shares - investors ignored that Pandora's profitability is threatened by increasing competition and costs. The company has provided nothing substantial to show it can overcome these threats and give investors solid returns.

"I wouldn't touch it with a 10-foot pole," Money Morning Chief Investment Strategist Keith Fitz-Gerald said on FoxBusiness' "Bulls & Bears." "Pandora has lost money for a decade and faces the same problem used car salesmen face to convert tire kickers to buyers."

Fitz-Gerald's fellow "Bulls & Bears" panel member Gary B. Smith agrees that Pandora's profitability is too questionable to be a good investment - at almost any price.

"At any price, unless it was maybe $1 or something, I wouldn't touch it," said Smith. "This is a company with 39 million active subscribers. They're losing money - in fact, every time they add a subscriber they lose money. I use Pandora, I like it - it's free, I would never pay for it."

The next Internet stock that could go public is gaming company Zynga Game Network Inc., which is also expected to use the low-float IPO maneuver. Rumors are swirling that it could file this month and make less than 10% of its shares available to the public.

"Companies in this space realize there's a feeding frenzy afoot," David Menlow, president of research firm, told Bloomberg News. "The risk is that as a CEO you believe you are better than you actually are. The reality may be something very different."

New Internet IPOs: A Place for "Fools"

With more Internet and social media start-ups expected to go public, investors should remember that most of these companies face many hurdles to sustainable growth, including increased competition and few barriers to entry.

"So-called social media companies are completely inappropriate for average investors," said Money Morning's Fitz-Gerald. "Every single one of these ‘social media' companies faces huge competition. There are already signs that this is cannibalizing the markets. There's no cutting edge technology, no defensible moat, nor critical relationships...nothing to make any of these companies unique."

The same goes for other Internet-related companies. Chicago-based Groupon, an e-commerce player that offers daily discounts to subscribers via e-mail, filed June 2 to go public and hoped to raise as much as $3 billion, valuing the company at $30 billion. That's five times as high as the $6 billion takeover bid Google Inc. (Nasdaq: GOOG) offered Groupon in December 2010 - a rapid jump many analysts can't explain.

Now Groupon has reason to worry that investors might take a closer look at the company's growing losses - $147 million, or 95 cents a share, in the first quarter this year - and wonder what they are actually paying for.

Perhaps the biggest test for investors trying to avoid the new tech bubble will be social networking site Facebook Inc., which is likely to deliver its IPO next year.

Facebook's IPO entry is being accelerated by the Security and Exchange Commission's 500 rule, which forces private companies that reach 500 investors to submit quarterly financials to the SEC, just like public companies. The company is on a path to hit 500 investors this year and would want to beat the reporting requirement and offer an IPO in 2012's first quarter, say sources familiar with the matter.

Facebook's value has soared to around $85 billion from $50 billion in January. By the time it goes public, its value could climb as high as $100 billion - much more than the company is actually worth.

"The only thing that a potential $100 billion valuation for Facebook implies is the greater fool theory," said Fitz-Gerald.

Those who rush to get in on social media and Internet-related IPOs run the risk that by the time they go to sell shares there are few fools left to buy, the theory goes. While the idea of a quick profit is tempting, it's best to wait for a company with the quality to support its valuation.

How to Avoid the New Tech Bubble

Fitz-Gerald said investors need to look past the hype and see what these companies actually bring to the table.

"You have to ask yourself: Does something like this merit a valuation that is almost as big as Intel Corp. (Nasdaq: INTC), or greater than Cisco Systems Inc. (Nasdaq: CSCO)?" said Fitz-Gerald. "And in the case of social media, I think the answer is no. I say short ‘em all."

Wall Street Daily's Chief Investment Strategist and IPO expert Louis Basenese suggested investors wait for a company that has a solid plan for profits. Those who don't could end up making the same mistake many investors did during the dot-com bubble in 2000.

"Focus on revenue and profitability," said Basenese. "Research out of the University of Florida demonstrates companies with at least $50 million in sales (for the trailing twelve months - ttm) and profits at the time of an IPO tend to outperform in the after market. During the last tech-driven IPO craze in 1999, most IPOs did not possess those two characteristics. And no surprise, most ultimately flopped."

The bottom line: Stay out of the social media IPOs. Unless their valuations deflate to more realistic prices, you'll be a victim of the new tech bubble.

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